Del. Chancery Court’s Ruling Offers Trade Secret Reminders For Startups

An emerging company often faces a tension with its potential outside investors over its trade secrets. The company wants to protect its trade secrets from competitors, so it often requires its directors — including those representing investors — to sign nondisclosure agreements.

This article was originally published in Law360*

On the other hand, investors often require the emerging company to acknowledge their right to invest in other companies in the same industry. The Delaware Court of Chancery recently addressed this tension, as well as the pleading obstacles that a company must overcome to raise a claim that its trade secrets were misappropriated.

Alarm.com, a home security company, alleged that its former private equity investor, ABS Capital Partners, improperly used its trade secrets to invest in a competing startup.[1] After ABS acquired a controlling stake in Alarm, the parties entered into a nondisclosure agreement requiring ABS to keep confidential any information it learned, but allowing ABS to continue investing in other security businesses, including rivals to Alarm. In 2009, the parties entered into a stockholders agreement and an ABS partner, Ralph Terkowitz, became chairman of Alarm’s board. Like the nondisclosure agreement, the stockholders agreement “contemplated that [ABS] might own equity in companies with businesses that were similar to Alarm’s.” A subsequent amended stockholders agreement permitted Terkowitz to continue serving as chairman and required the directors to protect the company’s trade secrets. The agreement also stated that ABS could invest in other companies, including Alarm’s rivals, as long as it did not disclose or use Alarm’s trade secrets in doing so. Finally, Alarm’s amended charter provided that ABS, Terkowitz and other ABS representatives had “no duty (contractual or otherwise) not to … engage in the same or similar business activities” as Alarm.

Terkowitz attended board meetings and reviewed documents containing Alarm’s most critical trade secrets, including its customer information, analyses of its competitors and the market, financial information, marketing strategies, and source code. After Alarm’s initial public offering, Terkowitz resigned. Only one year later, ABS acquired a significant ownership stake in a security firm that competes with Alarm, and another partner from ABS (not Terkowitz) joined that competitor’s board of directors.

Based on these allegations, Alarm brought suit against ABS under the Delaware Uniform Trade Secrets Act. It contended that Terkowitz obtained its trade secrets while serving as its chairman and disclosed them to his partners at ABS, including his partner who joined the board of Alarm’s competitor. Alarm added that even if ABS had not already disclosed its most important trade secrets to the rival company, ABS' exposure to those trade secrets made their disclosure all but inevitable because ABS could not “unlearn” them while operating Alarm’s rival.

But the Court of Chancery dismissed Alarm’s DUTSA claim because Alarm did not allege facts that permitted a court to reasonably infer that ABS had misappropriated its trade secrets. Alarm’s complaint relied only on the fact that ABS invested in its rival one year after Terkowitz left the board and after an auction in which ABS outbid other investors for Alarm’s rival. The court concluded that those circumstances “only support[ed] an inference that ABS invested in a company that competes with Alarm, just as Alarm and ABS always understood ABS could do.”

The court noted that this understanding that ABS could invest in competitor companies was confirmed by the nondisclosure agreement and by the parties’ subsequent agreements. As a result, ABS’ investment in Alarm’s competitor shortly after Terkowitz resigned was not enough by itself to enable the court to infer that ABS, through Terkowitz, had misappropriated or wrongfully disclosed Alarm’s trade secrets. For the court, this was particularly so because ABS had placed on Alarm’s rival’s board a representative other than Terkowitz and because Alarm’s amended charter waived claims for breaching the duty of loyalty by providing that ABS and Terkowitz had no duty to refrain from engaging in business similar to Alarm’s.

The court also concluded that DUTSA preempted Alarm’s common law misappropriation claim. Relying on DUTSA’s specific preemption provision, the Supreme Court of Delaware had already held that when “common law claims are based on the same alleged wrongful conduct as the trade secrets claims, they are precluded under [the DUTSA].” Applying that precedent, the court dismissed Alarm’s complaint against ABS in its entirety.

For companies considering trade secret litigation, the Alarm.com case illustrates the difficulty of alleging that another party misappropriated trade secrets. A plaintiff that files a claim for trade secret misappropriation typically must plausibly allege that the defendant used improper means to acquire a trade secret or misused that trade secret, but it often lacks details of the alleged misappropriation. Even though it can argue that it needs to enter the discovery stage to obtain more specific and compelling evidence of misappropriation, a plaintiff at the pleading stage may not have that evidence and may instead have to proceed with only circumstantial evidence. But when considering whether misappropriation can be inferred from circumstantial evidence, courts will also assess the parties’ agreements that set forth their rights, duties, and restrictions. Those rights, duties and restrictions often make it harder to plausibly allege that another party intentionally misappropriated or improperly disclosed trade secrets. This was shown in this case because ABS had negotiated to protect its rights to invest in other companies in the security industry.

Finally, for businesses negotiating investment and nondisclosure agreements, the case highlights another important issue. Investors that fund emerging companies will continue to try to protect their rights to explore other opportunities in that same industry in which they invest. But emerging companies that prioritize their trade secrets — often their most valuable assets — need to recognize that their ability to pursue claims for trade secret misappropriation depends not only on restrictions in the nondisclosure agreements, but also other agreements with business partners and investors that color the context of those restrictions and rights. As a result, those companies should carefully assess how terms in those other agreements may undermine their ability to protect their trade secrets.

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